Question

What information does the payback period provide?

Suppose you are evaluating a project with the expected future cash inflows shown in the following table. Your boss has asked you to calculate the project’s net present value (NPV). You don’t know the project’s initial cost, but you do know the project’s regular, or conventional, payback period is 2.50 years.

Year	Cash Flow
Year 1	$325,000
Year 2	$400,000
Year 3	$500,000
Year 4	$400,000

If the project’s weighted average cost of capital (WACC) is 8%, the project’s NPV (rounded to the nearest dollar) is:

$413,758

$395,769

$359,790

$431,748

Which of the following statements indicate a disadvantage of using the regular payback period (not the discounted payback period) for capital budgeting decisions? Check all that apply.

The payback period is calculated using net income instead of cash flows.

The payback period does not take the time value of money into account.

The payback period does not take the project’s entire life into accoun

Answer 1

Computation of initial investment amount

Pay Back period is nothing but at what time we can recover the entire investment amount

Given Pay Back period = 2.5 Years

That means within 2.5 Years we are able to recover our entire investmnet.

Let us add the Cashflows accruinng upto 2.5 Years to get the Initial investment amount

Intial investment = Year 1 iCashinflow+ Year 2 Cashinflow+0.5 ( Year 3 Cash inflow)

= $ 325000+ $ 400000+0.5( $ 500000)

= $ 325000+$ 400000+$ 250000

=$ 975000

Hence the initial investment amount is $ 975000.

Computation of Present Value of Cashinflows

Year	Cash inflow	Disc @ 8%	Discounting factor	Discounted Cashflow( Cashinflow* Discounting factor)
1	$325,000	1/( 1.08)^1	0.9259	$300,925.93
2	$400,000	1/( 1.08)^2	0.8573	$342,935.53
3	$500,000	1/( 1.08)^3	0.7938	$396,916.12
4	$400,000	1/( 1.08)^4	0.7350	$294,011.94
		Total		$1,334,789.52

Hence PV of Cashinflow is $ 1334789.52

We know that NPV = PV of Cashinflow-PV of initial outlay'

= $ 1334789.52-$ 975000

= $ 359790

Hence the NPV is $ 359790.

Hence 3rd option $ 359790 is correct

Pay back period Disadvantages

1. It does not Conider the entire lifespan of the Project. It only consider the Cashflow upto the recovery of the initial investment.

2.It also does not consider the time value of money which is very crucial in decision making. The money earned today is more valuable than tommorrow.

So option 2 and 3 will apply.

If you are having any doubts, please post a comment.

Thank you. Please rate it.